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SCHOOL OF MANAGEMENT STUDIES

UNIT – I -FINANCIAL MANAGEMENT– SBAA1307

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1. INTRODUCTION

Finance is the life blood of business. Finance may be defined as the art and science of

managing money. Finance also is referred as the provision of money at the time when it is

needed. Finance function is the procurement of funds and their effective utilization in

business concerns. The term financial management has been defined by Solomon, “It is

concerned with the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by S. C.

Kuchal is that “Financial Management deals with procurement of funds and their effective

utilization in the business. Financial management is the operational activity of a business that

is responsible for obtaining and effectively utilizing the funds necessary for efficient

operations. Thus, Financial Management is mainly concerned with the effective funds

management in the business.

Financial management is that activity of management which is concerned with the

planning, procuring and controlling of the firm's financial resources. It means applying

general management principles to financial resources of the institutions. Financial activities

of an institutions is one of the most important and complex activities of a firm. Therefore in

order to take care of these activities a financial manager performs all the requisite financial

activities. A financial manager is a person who takes care of all the important financial

functions of an organization. The person in charge should maintain a far sightedness in order

to ensure that the funds are utilized in the most efficient manner. His actions directly affect

the Profitability, growth and goodwill of the firm.

The scope and coverage of financial management have undergone fundamental

changes over the last half a century. During 1930s and 1940s, it was concerned of raising

adequate funds and maintaining liquidity and sound financial structure. This is known as the

'Traditional Approach' to procurement and utilization of funds required by a firm. Thus, it

was regarded as an art and science of raising and spending of funds. The traditional approach

emphasized the acquisition of funds and ignored efficient allocation and constructive use of

funds. It does not give sufficient attention to the management of working capital.

During 1950s, the need for most profitable allocation of scarce capital resources was

recognized. During 1960s and 1970s many analytical tools and concepts like funds flow

statement, ratio analysis, cost of capital, earning per share, optimum capital structure,

portfolio theory etc. were emphasized. As a result, a broader concept of finance began to be

used. Thus, the modern approach to finance emphasizes the proper allocation and utilization

of funds in addition to their economical procurement. Thus, business finance is defined as"

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the activity concerned with the planning, raising, controlling and administering of funds used

in the business."

Modern business finance includes –

(i) Determining the capital requirements of the firm.

(ii) Raising of sufficient funds to make an ideal or optimum capital structure

(iii) Allocating the funds among various types of assets

(iv) Financial control so as to ensure efficient use of funds.

1.2 DEFINITION OF FINANCIAL MANAGEMENT

“Financial management is the activity concerned with planning, raising, controlling and

administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of

capital and a careful selection of the source of capital in order to enable a spending unit to

move in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for

obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie

1.3 NATURE OF FINANCIAL MANAGEMENT

1. Financial Management is an integral part of overall management. Financial

considerations are involved in all business decisions. So financial management is

pervasive throughout the organisation.

2. In most of the organizations, financial operations are centralized. This results in

economies.

3. Financial management involves with data analysis for use in decision making.

4. The central focus of financial management is valuation of the firm. That is financial

decisions are directed at increasing/maximization/ optimizing the value of the firm.

5. Financial management essentially involves risk-return trade-off Decisions on

investment involve choosing of types of assets which generate returns accompanied

by risks. Generally higher the risk, returns might be higher and vice versa. So, the

financial manager has to decide the level of risk the firm can assume and satisfy with

the accompanying return.

6. Financial management affects the survival, growth and vitality of the firm. Finance is

said to be the life blood of business. It is to business, what blood is to us. The amount,

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type, sources, conditions and cost of finance squarely influence the functioning of the

unit.

7. Finance functions, i.e., investment, rising of capital, distribution of profit, are

performed in all firms - business or non-business, big or small, proprietary or

corporate undertakings.

8. Financial management is a sub-system of the business system which has other

subsystems like production, marketing, etc. In systems arrangement financial sub-

system is to be well-coordinated with others and other sub-systems.

9. Financial Management is the activity concerned with the control and planning of

financial resources.

10. Financial management is multi-disciplinary in approach. It depends on other

disciplines, like Economics, Accounting etc., for a better procurement and utilisation

of finances.

1.4 FINANCE AND OTHER RELATED DISCIPLINES :

Financial management is an integral part of the overall management, on other disciplines and

fields of study like economics, accounting, production, marketing, personnel and quantitative

methods. The relationship of financial management with other fields of study is explained

below

(i) Finance and Economics

Finance is a branch of economics. Economics deals with supply and demand, costs and

profits, production and consumption and so on. The relevance of economics to financial

management can be described in two broad areas of economics i.e., micro economics and

macroeconomics. Micro economics deals with the economic decisions of individuals and

firms. It concerns itself with the determination of optimal operating strategies of a business

firm. These strategies include profit maximization strategies, product pricing strategies,

strategies for valuation of firm and assets etc. The basic principle of micro economics that

applies in financial management is marginal analysis. Most of the financial decisions should

be made taken into account the marginal revenue and marginal cost. So, every financial

manager must be familiar with the basic concepts of micro economics. Macroeconomics

deals with the aggregates of the economy in which the firm operates. Macroeconomics is

concerned with the institutional structure of the banking system, money and capital markets,

monetary, credit and fiscal policies etc. So, the financial manager must be aware of the broad

economic environment and their impact on the decision making areas of the business firm.

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(ii) Finance and Accounting

Accounting and finance are closely related. Accounting is an important input in financial

decision making process. Accounting is concerned with recording of business transactions. It

generates information relating to business transactions and reporting them to the concerned

parties. The end product of accounting is financial statements namely profit and loss account,

balance sheet and the statements of changes in financial position. The information contained

in these statements assists the financial managers in evaluating the past performance and

future direction of the firm (decisions) in meeting certain obligations like payment of taxes

and so on. Thus, accounting and finance are closely related.

(iii) Finance and Production

Finance and production are also functionally related. Any changes in production process may

necessitate additional funds which the financial managers must evaluate and finance. Thus,

the production processes, capacity of the firm are closely related to finance.

(iv) Finance and Marketing

Marketing and finance are functionally related. New product development, sales promotion

plans, new channels of distribution, advertising campaign etc. in the area of marketing will

require additional funds and have an impact on the expected cash flows of the business firm.

Thus, the financial manager must be familiar with the basic concept of ideas of marketing.

(v) Finance and Quantitative Methods

Financial management and Quantitative methods are closely related such as linear

programming, probability, discounting techniques, present value techniques etc. are useful in

analyzing complex financial management problems. Thus, the financial manager should be

familiar with the tools of quantitative methods. In other way, the quantitative methods are

indirectly related to the day-to-day decision making by financial managers.

(vi) Finance and Costing

Cost efficiency is a major strategic advantage to a firm, and will greatly contribute towards its

competitiveness, sustainability and profitability. A finance manager has to understand, plan

and manage cost, through appropriate tools and techniques including Budgeting and Activity

Based Costing.

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(vii) Finance and Law

A sound knowledge of legal environment, corporate laws, business laws, Import Export

guidelines, international laws, trade and patent laws, commercial contracts, etc. are again

important for a finance executive in a globalized business scenario. For example the

guidelines of Securities and Exchange Board of India [SEBI] for raising money from the

capital markets. Similarly, now many Indian corporate are sourcing from international capital

markets and get their shares listed in the international exchanges. This calls for sound

knowledge of Securities Exchange Commission guidelines, dealing in the listing

requirements of various international stock exchanges operating in different countries.

(viii) Finance and Taxation

A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as

all financial decisions are likely to have tax implications. Tax planning is an important

function of a finance manager. Some of the major business decisions are based on the

economics of taxation. A finance manager should be able to assess the tax benefits before

committing funds. Present value of the tax shield is the yardstick always applied by a finance

manager in investment decisions.

(ix) Finance and Treasury Management

Treasury has become an important function and discipline, not only in every organization.

Every finance manager should be well grounded in treasury operations, which is considered

as a profit center. It deals with optimal management of cash flows, judiciously investing

surplus cash in the most appropriate investment avenues, anticipating and meeting emerging

cash requirements and maximizing the overall returns.

(x) Finance and Banking

Banking has completely undergone a change in today’s context. The type of financial

assistance provided to corporate has become very customized and innovative. Banks provides

both long term and short term finance, besides a number of innovative corporate and retail

banking products, which enable corporate to choose between them and reduce their cost of

borrowings. It is imperative for every finance manager to be up-to date on the changes in

services & products offered by banking sector including several foreign players in the field.

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(xi) Finance and Insurance

Evaluating and determining the commercial insurance requirements, choice of products and

insurers, analyzing their applicability to the needs and cost effectiveness, techniques,

ensuring appropriate and optimum coverage, claims handling, etc. fall within the ambit of a

finance manager’s scope of work & responsibilities.

(xii) International Finance

Capital markets have become globally integrated. Indian companies raise equity and debt

funds from international markets, in the form of Global Depository Receipts (GDRs),

American Depository Receipts (ADRs) or External Commercial Borrowings (ECBs) and a

number of hybrid instruments like the convertible bonds, participatory notes etc. Finance

managers are expected to have a thorough knowledge on international sources of finance,

merger implications with foreign companies, Leveraged Buy Outs (LBOs), acquisitions

abroad and international transfer pricing. This is an essential aspect of finance manager’s

expertise. Similarly, protecting the value of foreign exchange earned, through instruments

like derivatives, is vital for a finance manager as the volatility in exchange rate movements

can erode in no time, all the profits earned over a period of time.

(xiii) Finance and Information Technology

Information technology is the order of the day and is now driving all businesses. It is all

pervading. A finance manager needs to know how to integrate finance and costing with

operations through software packages including ERP. The finance manager takes an active

part in assessment of various available options, identifying the right one and in the

implementation of such packages to suit the requirement.

1.5 OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit maximization

It is commonly believed that a shareholders objective is to maximise profit. To achieve the

goal of profit maximisation, the financial manager takes only those actions that are expected

to make a major contribution to the firm's overall profits. The total earnings available for the

firm's shareholders is commonly measured in terms of earnings per share (EPS). Hence the

decisions and actions of finance managers should result in higher earnings per share for

shareholders.

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Points in favour of profit maximisation:

It is a parameter to measure the performance of a business

It ensures maximum welfare to the shareholders, employees and prompt

payment to the creditors

Increase the confidence of management in expansion and diversification.

It indicates the efficient use of funds for different requirements.

Points against profit maximisation:

It is not a clear term like accounting profit, before tax or after tax or net profit or gross

profit.

It encourage corrupt practices

It does not consider the element of risk

Time value of money is not reflected

Attracts cut –throat competition

Huge profits attracts government intervention

It invites problem from workers.

It affects the long run liquidity of a company.

2. Wealth Maximisation

The goal of the finance function is to maximise the wealth of the owners for whom the firm is

being carried on. The wealth of corporate owners is measured by the share prices of the stock,

which is turn is based on the timing of return, cash flows and risk. While taking decisions,

only that action that is expected to increase share price should be taken.

It considers :

(a) Time value of money on investment decision

(b) The risk or uncertainty of future earnings and

(c) effects of dividend policy on the market price of shares.

Points In favour of Wealth Maximisation

It is a clear term

Net effect of investment and benefits can be measured clearly.

It considers the time value for money.

It should be accepted universally

It guides the management in framing a consistent strong dividend policy to reach

maximum return to the equity holders

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.Points against wealth maximisation:

This concept is useful for equity share holders not for debenture holders

The expectations of workers, consumers and various interest groups create a greater

influence that must be respected to achieve long run wealth maximization and also for

their survival.

Basis Wealth Maximization Profit Maximization

Definition

It is defined as the management of

financial resources aimed at

increasing the value of the

stakeholders of the company.

It is defined as the management of

financial resources aimed at

increasing the profit of the company.

Focus

Focuses on increasing the value of

the stakeholders of the company in

the long term.

Focuses on increasing the profit of

the company in the short term.

Risk

It considers the risks and uncertainty

inherent in the business model of the

company.

It does not consider the risks and

uncertainty inherent in the business

model of the company.

Usage

It helps in achieving a larger value of

a company’s worth which may

reflect in the increased market share

of the company.

It helps in achieving efficiency in the

company’s day-to-day operations to

make the business profitable.

1.6 SCOPE OF FINANCIAL MANAGEMENT

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1. The Traditional Approach:

The traditional approach to the finance function relates to the initial stages of its evolution

during 1920s and 1930s . According to this approach, the scope, of finance function was

confined to only procurement of funds needed by a business on most suitable terms.

The utilisation of funds was considered beyond the purview of finance function. It was felt

that decisions regarding the application of funds are taken somewhere else in the

organisation. However, institutions and instruments for raising funds were considered to be a

part of finance function.

The traditional approach suffers from many serious limitations:

(i) It is outsider-looking in approach that completely ignores internal decision making as to

the proper utilisation of funds.

(ii) The focus of traditional approach was on procurement of long-term funds. Thus, it

ignored the important issue of working capital finance and management.

(iii) The issue of allocation of funds, which is so important today, is completely ignored.

2. The Modern Approach:

The modern approach views finance function in broader sense. It includes both rising of

funds as well as their effective utilisation under the purview of finance. The finance function

does not stop only by finding out sources of raising enough funds; their proper utilisation is

also to be considered. The cost of raising funds and the returns from their use should be

compared.

The funds raised should be able to give more returns than the costs involved in procuring

them. The utilisation of funds requires decision making. Finance has to be considered as an

integral part of overall management. So finance functions, according to this approach, covers

financial planning, rising of funds, allocation of funds, financial control etc.

The modern approach considers the three basic management decisions, i.e., investment

decisions, financing decisions and dividend decisions within the scope of finance function.

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In organizations, managers in an effort to minimize the costs of procuring finance and using it

in the most profitable manner, take the following decisions:

Investment Decisions: Managers need to decide on the amount of investment available out

of the existing finance, on a long-term and short-term basis. They are of two types:

Long-term investment decisions or Capital Budgeting mean committing funds for a long

period of time like fixed assets. These decisions are irreversible and usually include the ones

pertaining to investing in a building and/or land, acquiring new plants/machinery or replacing

the old ones, etc. These decisions determine the financial pursuits and performance of a

business.

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Short-term investment decisions or Working Capital Management means committing funds

for a short period of time like current assets. These involve decisions pertaining to the

investment of funds in the inventory, cash, bank deposits, and other short-term investments.

They directly affect the liquidity and performance of the business.

Financing Decisions: Managers also make decisions pertaining to raising finance from long-

term sources and short-term sources. They are of two types:

Financial Planning decisions which relate to estimating the sources and application of funds.

It means pre-estimating financial needs of an organization to ensure the availability of

adequate finance. The primary objective of financial planning is to plan and ensure that the

funds are available as and when required.

Capital Structure decisions which involve identifying sources of funds. They also involve

decisions with respect to choosing external sources like issuing shares, bonds, borrowing

from banks or internal sources like retained earnings for raising funds. The decisions are

made in the light of the cost of capital, risk factor involved and returns to the shareholders.

Dividend Decisions: These involve decisions related to the portion of profits that will be

distributed as dividend. Dividend is that portion of divisible profits that is distributed to the

owners i.e. the shareholders. Retained earnings is the proportion of profits kept in, that is,

reinvested in the business for the business. Shareholders always demand a higher dividend,

while the management would want to retain profits for business needs. Dividend decision is

to whether to distribute earnings to shareholder as dividends or retain earnings to finance

long-term profits of the firm. It must be done keeping in mind the firms overall objective of

maximizing the shareholders wealth.

1.7 ORGANIZATION OF FINANCE FUNCTION

Finance, being an important portfolio, the finance functions is entrusted to top management.

The Board of Directors, who are at the helm of affairs, normally constitutes a ‘Finance

Committee’ to review and formulate financial policies. Two more officers, namely ‘treasurer’

and ‘controller’ – may be appointed under the direct supervision of CFO to assist him/her. In

larger companies with modern management, there may be Vice-President or Director of

finance, usually with both controller and treasurer. The organization of finance function is

portrayed below

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The terms ‘controller’ and ‘treasurer’ are in fact used in USA. This pattern is not popular in

Indian corporate sector. Practically, the controller / financial controller in India carried out

the functions of a Chief Accountant or Finance Officer of an organization. Financial

controller who has been a person of executive rank does not control the finance, but monitors

whether funds so augmented are properly utilized.

The function of the treasurer of an organization is to raise funds and manage funds. The

treasures functions include forecasting the financial requirements, administering the flow of

cash, managing credit, flotation of securities, maintaining relations with financial institutions

and protecting funds and securities. The controller’s functions include providing information

to formulate accounting and costing policies, preparation of financial reports, direction of

internal auditing, budgeting, inventory control payment of taxes, etc.

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1.8 DUTIES AND RESPONSIBILITIES OF FINANCIAL MANAGER (OR)

FUNCTIONS OF FINANCIAL MANAGER (OR) ROLE OF FINANCIAL

MANAGER.

Finance manager is an integral part of corporate management of an organization. With his

profession experience, expertise knowledge and competence, he has to play a key role in

optimal utilization of financial resources of the organization. With the growth in the size of

the organization, degree of specialization of finance function increases. In large undertakings,

the finance manager is a top management executive who participants in various decision

making functions.

A) Determining financial needs:-

One of the most important functions of the financial manager is to ensure the availability

of adequate financing, financial needs have to be assessed for different purposes. Money may

be required for initial promotional expenses, fixed capital and working capital needs.

Promotional expenditure includes expenditure incurred in the process of company formation.

B) Determining sources of funds:-

The financial manager has to choose source of funds. He may issue different types of

securities and debenture, may borrow form a number of finance institutional and the public.

The financial manager must definitely know what he is doing, workout strategies to ensure

good financial health of the firm.

C) Financial analysis:-

It is the evaluation & interpretation of a firm’s financial position and operation and involves a

comparison and interpretation of accounting data. The financial manager has to interpret

different statements.

D) Optimal capital structure:-

The financial manager has to establish an optimum capital structure and ensure the

maximum rate of return on investment and the liabilities carrying – fixed charges has to be

defined.

E) Cost –volume profit analysis;-

This is popularly known as the CVP relationship for this purpose are fixed cost, variable

cost and semi-variable cost have to be analyzed.

F) Profit planning and control:-

Profit planning and control have assumed great importance in the financial activities of

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morden business. Profit planning ensures the attainment of stability and growth. The break

even analysis and cost volume profit it analysis are important tools in profit planning and

control of the firms.

G) Fixed assets management:-

A firms fixed assets are land, building, machinery and equipment, furniture and such

intangibles as patents, copy rights and goodwill. These fixed assets are justified to the extent

of the utility or their production capacity.

H) Capital budgeting:-

It refers to the long-term planning for (1) investment in projects and fixed assets and

(2)methods of financing the approved projects. It includes the methods of mobilization of

long-terms funds and their deployments in profitable projects. Capital budgeting is

considered as the process of making investment decisions on capital expenditure.

I) Dividend policies:-

The dividend policy of a firm determines the magnitude of the earnings distributed to share

holders. The net operating profit or profit after tax (PAT) has to be intelligently apportioned

between divided payments, and investments. The dividend policy determines the amount of

dividend payment to be made to the shareholders, the date of payments of dividends and the

effect of the dividend policy on the value of the firm.

J) Acquisition and mergers:-

A merger is a transaction where two firms agree to integrate their operations on a relatively

equal basis because they have resources and capabilities that together may create a stronger

competitive advantage. Two or more companies combine to form either a new company or

one of the combining companies survives, which is generally the acquirer.

1.9 SOURCES OF FINANCE

A] LONG TERM FINANCE

Financing means providing money for investment in the form of fixed assets and also in the

form of working capital needed for day to day operations

(I)EXTERNAL SOURCES:

1. Owned capital (Preference and Equity Capital)

2. Debentures

3. Public Deposits

4. Lease Financing

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5. Hire Purchase

6. Institutional Assistance

7. Government subsidies

8. Mortgage Bonds

9. Venture Capital

(II) INTERNAL SOURCES:

1. Retained earnings

2.Provision for Depreciation

EXTERNAL SOURCES:

1. Preference Shares:

Preference shares have two preferential rights. One at the time of payment of dividend and

second repayment of capital at the time of liquidation of the company

The company has the following advantages by this way of source:

No voting rights and normally has no control over the policies.

Finance through preference shares is less costly as compared to the equity shares.

The disadvantages of raising funds by way of preference capital are:

Compared to equity capital it is a very expensive source of financing.

Though there is no legal obligation to pay preference dividends, skipping them can

adversely affect the image of the firm in the capital market.

2. Equity Shares:

The equity shares are the main sources of finance and the owners of the company contribute

it. It is the source of permanent capital since it does not have a maturity date. The holders of

equity shares have a control over the working of the company. These shares are issued

without creating any charge over the assets of the company.

The major advantage to raise funds through equity shares is that it does not involve any fixed

obligation for payment of dividends. The disadvantage of raising funds by way of equity

capital is high cost of capital. The rate of return required by equity shareholders is generally

higher than the rate of return required by other investors.

3. Debentures:

Debentures are certificates issued by the company acknowledging the debt due by to its

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holders with or without a charge on the assets of the company. A fixed interest has to be paid

regularly till the principal has been fully repaid by the company.

4. Institutional Assistance:

The Government has set up certain special financial corporation with the object of

stimulating industrial development in the country. These include IFC, SFC, ICICI, IDBI etc

5. Public Deposits:

Public deposits are the another important source for the firms. Companies prefer public

deposits because, these deposits carry lower rate of interest

6. Lease Finance:

Lease financing involves the acquisition of the economic use of an asset through a contractual

commitment to make periodic payments called lease rentals to the person who owns the asset.

Thus this is a mode of financing to acquire the use of assets.

7. Hire Purchase:

Assets involving huge amounts if other sources of long-term finance are too costly may be

acquired through hire purchase.

8. Government Assistance:

The government provides finance to companies in cash grants and other forms of direct

assistance, as part of its policy of helping to develop the national economy, especially in high

technology industries and in areas of high unemployment. Government subsidies and

concessions are other modes of financing long-term requirement. Subject to the government

regulations, subsidies and concessions are granted to business enterprises.

9. Mortgage Bonds:

It is a written promise given by the company to the investor to repay a specified sum of

money at a specified rate of interest at a specified time

10. Venture capital

Venture capital is the Money provided by investors to startup firms and small businesses with

perceived long-term growth potential. This is a very important source of funding for startups

that do not have access to capital markets. It typically entails high risk for the investor, but it

has the potential for above-average returns.

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INTERNAL SOURCES

1. Retained Earnings :

A company out of its profits, a certain percentage is retained that amount is reinvested into

the business for its development. This is also known ploughing back of profits

2. Provision for depreciation:

Depreciation means decrease in the value of the asset due to wear and tear, lapse of time and

accident. Provision for depreciation considered as one of the source of financing to business.

B] SHORT TERM SOURCES

The sources of short-term funds used for financing variable part of working capital mainly

include the following:

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security.

This method of financing does not require any legal formality except that of creating a

mortgage on the assets. Loan can be paid in lump sum or in parts

2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting

shareholders, employees and the general public to deposit their savings with the company. It

is a simple method of raising funds from public for which the company has only to advertise

and inform the public that it is authorised by the Companies Act 1956, to accept public

deposits.

3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components and other

goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e.,

trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers

grant credit to their clients for a period of 3 to 6 months. Thus, they provide, in a way, short-

term finance to the purchasing company.

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4. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the

buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the

writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them

with commercial banks on payment of a charge known as discount.

5. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and

receivables in a better manner. The book debts and receivables are assigned to a bank called

the ‘factor’ and cash is realised in advance from the bank. For rendering these services, the

fee or commission charged is usually a percentage of the value of the book debts/receivables

factored. This is a method of raising short-term capital and known as ‘factoring’.

6. Bank Overdraft

Overdraft is a facility extended by the banks to their current account holders for a short-

period generally a week. A current account holder is allowed to withdraw from its current

deposit account up to a certain limit over the balance with the bank. The interest is charged

only on the amount actually overdrawn. The overdraft facility is also granted against

securities.

7. Cash Credit:

Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a

specified-limit known as ‘cash credit limit.’ The cash credit facility is allowed against the

security. The cash credit limit can be revised from time to time according to the value of

securities. The money so drawn can be repaid as and when possible. The interest is charged

on the actual amount drawn during the period rather on limit sanctioned.

Arranging overdraft and cash credit with the commercial banks has become a common

method adopted by companies for meeting their short- term financial, or say, working capital

requirements.

8. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from one’s

own customers. Examples of advances from the customers are advance paid at the time of

booking a car, a telephone connection, a flat, etc. This has become an increasingly popular

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source of short-term finance among the small business enterprises mainly due to two reasons.

The enterprises do not pay any interest on advances from their customers. Thus, advances

from customers become one of the cheapest sources of raising funds for meeting working

capital requirements of companies.

9. Accrual Accounts:

Generally, there is a certain amount of time gap between incomes is earned and is actually

received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for

example, become due at the end of the month but are usually paid in the first week of the next

month. Thus, the outstanding salaries and wages as expenses for a week helps the enterprise

in meeting their working capital requirements. This source of raising funds does not involve

any cost.

1.10 TIME VALUE OF MONEY

Let’s start a discussion on Time Value of Money by taking a very simple scenario. If you are

offered the choice between having Rs 10,000 today and having Rs 10,000 at a future date,

you will usually prefer to have Rs 10,000 now. Similarly, if the choice is between paying Rs

10,000 now or paying the same Rs 10,000 at a future date, you will usually prefer to pay Rs

10,000 later. It is simple common sense. In the first case by accepting Rs 10,000 early, you

can simply put the money in the bank and earn some interest. Similarly in the second case by

deferring the payment, you can earn interest by keeping the money in the bank.

The idea that money available at the present time is worth more than the same amount in the

future due to its potential earning capacity is called the time value of money. This core

principle of finance holds that, provided money can earn interest, any amount of money is

worth more the sooner it is received. Thus, at the most basic level, the time value of money

demonstrates that, all things being equal, it is better to have money now rather than later.

Reasons Why Money Can Be More Valuable Today Than In The Future

There are three reasons why money can be more valuable today than in the future.

(i) Preference for Present Consumption: Individuals have a preference for current

consumption in comparison to future consumption. In order to forego the present

consumption for a future one, they need a strong incentive. Say for example, if the

individual’s present preference is very strong then he has to be offered a very high

21

incentive to forego it like a higher rate of interest and vice versa.

(ii) Inflation: Inflation means when prices of things rise faster than they actually

should. When there is inflation, the value of currency decreases over time. If the

inflation is more, then the gap between the value of money today to the value of

money in future is more. So, greater the inflation, greater is the gap and vice versa.

(iii) Risk: Risk of uncertainty in the future lowers the value of money. Say for

example, non-receipt of payment, uncertainty of investor’s life or any other

contingency which may result in non-payment or reduction in payment.

Discounting is the process of determining the present value of a future payment or stream of

payments. A Rupee is always worth more today than it would be worth tomorrow, according

to the concept of the time value of money. The present value formula shows you how much

once single cash payment (FV) received in a future time period (t) is worth in today’s terms

(PV). The present value of a sum is the current value of the amount that would be received in

the future. Computing the present value of a sum is known as discounting.

1.11 RISK AND RETURNS

Risk : A person making an investment expects to get some returns from the investment in the

future. However, as future is uncertain, the future expected returns too are uncertain. It is the

uncertainty associated with the returns from an investment that introduces a risk into a

project. Risk is defined as the chance that an outcome or investment's actual returns will

differ from an expected return

Return: It can be defined as the actual income from a project as well as appreciation in the

value of capital. Thus there are two components in return—the basic component or the

periodic cash flows from the investment, either in the form of interest or dividends; and the

change in the price of the asset, commonly called as the capital gain or loss.

Total Return = Cash payments received + Price change in assets over the period /Purchase

price of the asset.

The risk-return tradeoff is an investment principle that indicates that the higher the risk, the

higher the potential reward. To calculate an appropriate risk-return tradeoff, investors must

consider many factors, including overall risk tolerance, the potential to replace lost funds and

more. Investors consider the risk-return tradeoff on individual investments and across

portfolios when making investment decisions. The risk-return tradeoff states that the potential

return rises with an increase in risk. Using this principle, individuals associate low levels of

22

uncertainty with low potential returns, and high levels of uncertainty or risk with high

potential returns. According to the risk-return tradeoff, invested money can render higher

profits only if the investor will accept a higher possibility of losses.

Fig 1.3 Showing Risk and Return trade off

1

SCHOOL OF MANAGEMENT STUDIES

UNIT – II -FINANCIAL MANAGEMENT– SBAA1307

2

2. INVESTMENT DECISION

2.1 CAPITAL BUDGETING

The term capital budgeting or investment decision means planning for capital assets. Capital

budgeting decision means the decision as to whether or not to invest in long-term projects

such as setting up of a factory or installing a machinery etc. It includes the financial analysis

of the various proposals regarding capital expenditure to evaluate their impact on the

financial condition of the company for the purpose to choose the best out of the various

alternatives.

Capital expenditure is the expenditure is incurred at one point of time where as the benefits of

the expenditure are realized over a period of time. Capital budgeting can be defined as the

process of deciding whether or not to commit resources to projects whose cost and benefits

are spread over time periods.

2.1.1 DEFINITION OF CAPITAL BUDGETING

According to Charles T. Horngren, “Capital Budgeting is long-term planning for making and

financing proposed capital outlays.”

According to L.J. Gitman, “Capital Budgeting refers to the total process of generating,

evaluating, selecting and following up on capital expenditure alternatives.”

2.2 NATURE OF CAPITAL BUDGETING

It is a long-term investment decision.

It is irreversible in nature.

It requires a large amount of funds.

It is most critical and complicated decision for a finance manager.

It involves an element of risk as the investment is to be recovered in future.

2.3 IMPORTANCE OF CAPITAL BUDGETING

All capital expenditure projects involve heavy investment of funds ,the firm from various

external and internal sources raises these funds .hence it is important for a firm to plan its

capital expenditure.

3

1. Permanent commitment of funds

The funds capital expenditure projects are not only huge but more or less permanently

blocked These are long term decision .The longer the time the greater the risk is involved

Hence careful planning is essential

2. Irreversible in nature

In most cases, capital budgeting decision are irreversible .once the decision for acquiring a

permanent assets is taken ,it is very difficult to reverse the decision .This is because it is

difficult to dispose the assets without incurring heavy losses.

3. Growth and Expansion

Business firm grow, expand, diversify and acquire stature in the industry through their capital

budgeting activities. The success of mobilization and deployment of funds determines .the

future of a firm

4. Multiplicity of variables

Large number of factors affect the decision on capital expenditure ,They make the capital

expenditure decision the most difficult to make

5. Top management activity

The net result of capital expenditure' decisions automatically trusts them on the top

management. Only senior managerial personnel can take these decisions and boar

responsibility for them.

2.6 FACTORS ( Criteria ) INFLUENCING CAPITAL EXPENDITURE DECISIONS:

1. Availability of funds:

This is the crucial factor affecting all capital expenditure decisions However attractive, some

projects cannot be taken up if they are too big for a firm to mobilize the needed funds.

2. Future earnings:

Every project has to result in cash inflows. The extent of the revenue's anticipated is the most

significant factor which affects the choice of a project.

3. Degree of uncertainty or risk:

This level of risk involved in a project is vital for deciding its desirability.

4

4. Urgency :

Projects which are to be immediately taken up for firm's survival have to be treated

differently from optional projects.

5. Obsolescence:

It obsolete machinery and plant exist in a firm, their replacement becomes a compulsion.

6. Competitors activities

When competitors perform certain activities, they compel a firm to undertake similar

activities to withstand competition.

7. Intangible Factors:

Firm's prestige, workers' safety, social welfare etc, influence Capital budgeting which

may be deemed as emotional factors.

2.7 ADVANTAGES OF CAPITAL BUDGETING

1. Evaluates Investment Plans

Capital budgeting is a key tool used by management for the evaluation of investment

projects. It assists in taking decisions regarding long term investments by properly analyzing

investment opportunities. Using the capital budgeting techniques-risk, return and investment

amount of each project is examined.

2. Identify Risk

It enables in identifying the risk associated with investment plans. Capital budgeting

examines the project from different aspects to find out all possible losses and risks. It studies

how these risks affect the return and growth of the business which are helpful in making an

appropriate decision.

3. Chooses Investment Wisely

Capital budgeting plays an effective role in selecting a profitable investment project for the

business. It is the one that decides whether a particular project is beneficial to take or not.

This technique considers cash flows of investment proposal during its entire life for finding

out its profitability. Companies are able to choose investment wisely by analyzing different

factors in a competitive market using capital budgeting techniques.

5

4. Avoid Over and Under Investment

Managers use capital budgeting techniques to determine the appropriate investment amount

for the business. The right amount of investment is a must for every business for earning

better returns and avoiding losses. Capital budgeting analyses the firm capability and

objectives for determining the right investment accordingly.

5. Maximize Shareholder’s Wealth

Capital budgeting assists in maximizing the overall value of shareholders. It is a tool that

enables companies to deploy their funds in the most effective way possible thereby earning

huge profits. Companies are able to select investments with higher returns and lower costs

which eventually raises the shareholder’s wealth.

6. Control Project Expenditure

Capital budgeting focuses on minimizing the expenditure of investment projects. While

examining the investment proposals, it ensures that the project has an adequate amount of

inflows for meeting out its expenses and provide an anticipated return. The selection of

effective investment projects helps companies in controlling their expenditure and earning

better profits.

2.8 DISADVANTAGES OR LIMITATIONS OF CAPITAL BUDGETING

1. Irreversible Decisions

The major limitation with capital budgeting is that the decisions taken through this process

are long-term and irreversible in nature. Decisions have an impact on the long term durability

of the company and require the utmost care while taking them. Any wrong capital budgeting

decision would have an adverse effect on profitability and continuity of business.

2. Rely on Assumptions and Estimations

Capital budgeting techniques rely on different assumptions and estimations for analyzing

investment projects. Annual cash flow and life of project estimated is not always true and

may increase or decrease than the anticipated values. Decisions taken on the basis of these

untrue estimations may lead businesses to losses.

6

3. Higher Risk

Capital budgeting decisions are riskier in nature as it involves a large amount of capital

expenditure. These decisions require the utmost care as it affects the success or failure of

every business. Any wrong decisions regarding allotment of funds may lead the business to

substantial losses or eventually cause a complete shutdown.

4. Uncertainty

This process is dependent upon futuristic data which is uncertain for analyzing the investment

proposals. Capital budgeting anticipates the future cash inflows and outflows of the project

for determining its profitability. The future is always uncertain and data may prove untrue

which leads to wrong decisions.

5. Ignores Non-Financial Aspects

Capital budgeting technique considers only financial aspects and ignores all non-financial

aspects while analyzing the investment plans. Non-financial factors have an efficient role in

the success and profitability of the project. The real profitability of the project cannot be

determined by ignoring these factors

2.9 CAPITAL BUDGETING TECHNIQUES

The capital budgeting appraisal methods are techniques of evaluation of investment proposal

will help the company to decide upon the desirability of an investment proposal depending

upon their; relative income generating capacity and rank them in order of their desirability.

These methods provide the company a set of norms on the basis of which either it has to

accept or reject the investment proposal. The most widely accepted techniques used in

estimating the cost-returns of investment projects can be grouped under two categories.

I. Traditional methods

II. Discounted Cash flow methods

I. Traditional methods

These methods are based on the principles to determine the desirability of an investment

project on the basis of its useful life and expected returns. These will not take into account the

concept of ‘time value of money’, which is a significant factor to determine the desirability of

a project in terms of present value.

7

A) PAY-BACK PERIOD METHOD:

It is the most popular and widely recognized traditional method of evaluating the investment

proposals. It can be defined, as ‘the number of years required to recover the original cash out

lay invested in a project’. According to Weston & Brigham, “The pay back period is the

number of years it takes the firm to recover its original investment by net returns before

depreciation, but after taxes”.According to James. C. Vanhorne, “The payback period is the

number of years required to recover initial cash investment.

If the annual cash Inflows are constant or uniform, the pay back period can be computed by

dividing cash outlay by annual cash Inflows.

If the cash Inflows are not uniform: Pay back period is calculated by computing cumulative

cash inflows . Payback period is the period when net cash Inflows is equal to initial

investment

Merits:

It is one of the earliest methods of evaluating the investment projects.

It is simple to understand and to compute.

It is one of the widely used methods in small scale industry sector

It can be computed on the basis of accounting information available from the books.

Demerits

It does not take into account the life of the project, depreciation, scrap value Interest

factor etc.

It completely ignores cash inflows after the pay back period.

The profitability of the project is completely ignored

It ignores the time value of money; cash Inflows deceived in different years are

treated equally.

B) ACCOUNTING OR AVERAGE RATE OF RETURN

Accounting Rate of Return (ARR) is the average net income an asset is expected to generate

divided by its average capital cost, expressed as an annual percentage. They typically include

situations where companies are deciding on whether or not to proceed with a specific

8

investment (a project, an acquisition, etc.) based on the future net earnings expected

compared to the capital cost. This method called accounting rate of return method because it

fees the accounting concept of profit. i.e. income after depreciation and tax as the criterion for

calculation of return.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as the

ratio of accounting net income to the initial investment.

Accounting Rate of return (on Original Investment)

ARR = Average Annual Profit / Initial Investment

Average Annual Profit = 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑇𝑎𝑥

𝑁𝑜 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

Accounting Rate of return (on Average Investment)

ARR = Average Annual Profit / Average Investment

Average Investment = Initial Investment/2

In terms of decision making, if the ARR is equal to or greater than the required rate of return,

accept the project. If the ARR is less than the required rate of return, the project should be

rejected. Higher ARR indicates higher profitability.

Merits:

This method is easy to understand and simple to calculate.

This method takes into account the earnings over the entire economic life of the

project.

It is really a profitability concept since it considers net earnings after depreciation.

This method is in consistent with the conventional accounting system and easy to

comprehend as it based on percentages.

Demerits:

It ignores time value of money.

This method ignores the risk and uncertainty factors

It uses accounting profits and not the cash inflows in appraising the project.

It considers only the rate of return and not the life of the project.

9

Two formulas are used to compute this method. Each method gives different results.

This reduces the reliability of the method.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give

equal weight age to the present and future flow of incomes. The DCF methods are based on

the concept that a rupee earned today is more worth than a rupee earned tomorrow. These

methods take into consideration the profitability and also time value of money. Discounted

Cash flow techniques includes

Net present value method

Profitability Index method

Net Terminal Value method

Internal rate of return method

A) NET PRESENT VALUE METHOD:

The NPV takes into consideration the time value of money. The cash flows of different

years and valued differently and made comparable in terms of present values for this the

net cash inflows of various period are discounted using required rate of return which is

predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the

required rate of return minus the present value of the cost of the investment.” NPV is the

difference between the present value of cash inflows of a project and the initial cost of the

project. If NPV is positive (i.e.greater than 0) Accept the project. If NPV is negative (i.e

less than 0) Reject the project . When comparing NPV values of two or more projects

always select a project with greater NPV. While comparing different NPV values a high

NPV value indicates higher profitability.

Merits:

It recognizes the time value of money.

It is based on the entire cash flows generated during the useful life of the asset

It is consistent with the objective of maximization of wealth of the owners.

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The ranking of projects is independent of the discount rate used for determining the

present value.

Demerits:

It is different to understand and use.

The NPV is calculated by using the cost of capital as a discount rate. But the concept

of cost of capital. If self is difficult to understood and determine.

It does not give solutions when the comparable projects are involved in different

amounts of investment.

B) PROFITABILITY INDEX METHOD:

Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI

approach measures the present value of returns per rupee invested. It is observed in

shortcoming of NPV that, being an absolute measure, it is not a reliable method to evaluate

projects requiring different initial investments. The PI method provides solution to this kind

of problem.

It can be defined as the ratio which is obtained by dividing the present value of future cash

inflows by the present value of cash outlays

Using the PI ratio, Accept the project when PI>1 Reject the project when PI

11

Demerits:

Though PI is a sound method of project appraisal and it is just a variation of the NPV,

it has all those limitation of NPV method too

C) NET TERMINAL VALUE METHOD:

The terminal value method is an improvement over the net present value method of making

capital investment decisions This method is based on the assumption that operating savings

(cash inflows) of each year is reinvested in another outlet at a certain rate of return from the

moment of its receipt till the end of the economic life of the project. However, cash inflows

of the last year of the project will not be reinvested. As such, the compounded values of cash

inflows should be determined by the following formula-

A = P (1 + i)n, where P = 1

The total sum of compounded cash inflows would be assumed to have been received at the

end of the life of the project and hence should be discounted at present values on the basis of

discounting rate. The present values of compounded cash inflows should be compared with

present values of cash outflows.

If present values of compounded cash inflows are higher than present values of cash outflows

(initial outlay) the project should be accepted, otherwise it should be rejected. The

management will be indifferent, if both are equal. Like N.P.V., we can also calculate Net

Terminal Value (N.T.V.) and if it comes positive, the project should be accepted.

Steps

Note down the no of Years

Note down the Cash Inflows

Note down the Compounding Rate of Interest

Calculate the available Years for Investment (Total Years -corresponding year)

Compute Compounding Factor : Refer Compounding Table or Use the formula

Compounding Factor = (1+𝑟

100)n

Calculate Compounded Value of cash inflows:

Compounded Value of cash Inflows= Cash Inflows * compounding Factor

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Determine Present Value of Total compounded Cash Inflows using the formula

Compounded Value of Cash Inflows

(1+𝑘)𝑛

Merits:

This method incorporates the assumption about how the cash inflows are reinvested

once they are received and thus avoids any influence of the cost of capital on cash

inflows.

It is mathematically easier and makes the evaluation procedure simple.

It is easier to be understood by those business executives who are not trained in

accounting or economics.

It is more suitable where cash budget is in operation.

Demerits:

The most limiting aspect of this method is related to the projection of rates of return at

which cash inflows of different years may be reinvested.

It fails to make comparative evaluation of two or more mutually exclusive proposals.

D) INTERNAL RATE OF RETURN METHOD:

The IRR for an investment proposal is that discount rate which equates the present value of

cash inflows with the present value of cash out flows of an investment. The IRR is also

known as cutoff or handle rate. It is usually the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the

present value of the expected future receipts to the cost of the investment outlay. The IRR is

not a predetermine rate, rather it is to be trial and error method. It implies that one has to start

with a discounting rate to calculate the present value of cash inflows. If the obtained present

value is higher than the initial cost of the project one has to try with a higher rate. Like wise if

the present value of expected cash inflows obtained is lower than the present value of cash

flow. Lower rate is to be taken up. The process is continued till the net present value becomes

Zero. As this discount rate is determined internally, this method is called internal rate of

return method.

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Steps

Step 1: Select 2 discount rates for the calculation of NPVs

You can start by selecting any 2 discount rates on a random basis that will be used to

calculate the net present values in Step 2.

Step 2: Calculate NPVs of the investment using the 2 discount rates

You shall now calculate the net present values of the investment on the basis of each discount

rate selected in Step 1.

Step 3: Calculate the IRR

Using the 2 net present values derived in Step 2, you shall calculate the IRR by applying the

IRR Formula

Step 4: Interpretation

The decision rule for IRR is that an investment should only be selected where the cost of

capital (WACC) is lower than the IRR.

Merits:

It consider the time value of money

It takes into account the cash flows over the entire useful life of the asset.

It always suggests accepting to projects with maximum rate of return.

It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:

It is very difficult to understand and use.

It involves a very complicated computational work.

It may not give unique answer in all situations.

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Compare and contrast NPV and IRR methods:

Similarities Between NPV and IRR

• Both are the modern techniques of capital budgeting.

• Both are considering the time value for money.

• Both takes into consideration the cash flow throughout the life of the project.

Difference between NPV and IRR

• Concept : Net Present value (NPV) discounts the stream of expected cash flows associated

with a proposed project to their current value, which presents a cash surplus or loss for the

project. IRR where as, the Internal Rate of Return (IRR) calculates the percentage rate at

which those same cash flows result in a Net Present Value of Zero.

• Purpose: The NPV Method focuses on project surpluses .While the IRR Method focuses on

the breakeven cash flow of a project.

• Expressed in: NPV is expressed in Absolute terms. Whereas, IRR is expressed in

percentage terms.

• Decision Making: Decision making is easy in Net present value but not in IRR.

2.10 CAPITAL RATIONING:

Capital rationing is a situation where a firm has more investment proposals than it can

finance. Many concerns have limited funds. Therefore, all profitable investment proposals

may not be accepted at a time. In such event the firm has to select from amongst the various

competing proposals, those which give the highest benefits. There comes the problem of

rationing them. Thus capital rationing may be define as a situation where the management

has more profitable Investment proposal requiring more amount of finance than the funds

available to firms. In such a situation the firm has not only to rank the project from the

highest to lowest priority

15

CAPITAL BUDGETING- Exercise

PAYBACK PERIOD METHOD

1. Initial investment of a project is Rs.2,00,000. Annual cash inflow is Rs.40,000.

Calculate Pay Back Period.

(Ans. 5 years)

2. Initial project cost Rs.80000 and the net cash inflow after tax but before depreciation

are estimated for the next six years are Rs.20,000, Rs.25,000, Rs.20,000, Rs.30,000,

Rs.35,000 and Rs.15,000 respectively. Calculate Pay Back Period.

(Ans. 3 years 6 months)

3. Evaluate the following two projects based on pay back period criterion

Particulars Project X Project Y

Original Investment 35,000 15,000

Annual cash inflow 15,000 7,500

Economic life of project 7 years 3 years

(PBP Project X 2.33 years and project Y 2 years)

4. The company has to choose one of the following two projects, both requires an initial

investment of Rs.15,000

Year Cash inflows

Project X (Rs.) Project Y (Rs.)

1 4,200 4,200

2 4,800 4,500

3 7,000 4,000

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4 7,000 5,000

5 2,000 10,000

Assess the project by Pay Back Period method.

ACCOUNTING RATE OF RETURN

5. A company is considering an investment of Rs.10,00,000 in a project. The following

are the income forecast after depreciation and tax:

Year I II III IV V

Cash inflows (Rs.) -1,00,000 3,00,000 4,00,000 2,00,000 2,00,000

Calculate Accounting Rate of Return on original investment method and average

investment method.

(Ans. Original investment 20% and Average investment 40%)

6. A company is under consideration of investing in a project costing Rs.2,00,000. The

forecasted annual income are as follows:

Year I II III IV V

Cash inflows (Rs.) 1,00,000 1,00,000 80,000 80,000 40,000

Assess the project by ARR method.

(Ans. Original investment 40% and Average investment 80%)

7. A company is in consideration of making an investment of Rs.10,00,000 in a project.

The following are the forecasted income from the project:

Year I II III IV V

Cash inflows (Rs.) 1,00,000 3,00,000 4,00,000 2,00,000 2,00,000

Evaluate the project by ARR method.

(Ans. Original investment 24% and Average investment 48%)

17

NET PRESENT VALUE METHOD

8. The Initial outlay of the project is Rs.50,000. The Discounting rate is 10%. Calculate

NPV and comment on feasibility of the project. The cash inflows at the end of each

year are as follows

Year Machine A (Rs.)

1 20,000

2 30,000

3 35,000

9. Project X initially requires an investment of Rs.25,000. The expected annual inflow

are as follows:

Year Cash inflow (Rs.) Present value of 1rupee at 10%

1 9,000 .909

2 8,000 .826

3 7,000 .751

4 6,000 .683

5 5,000 .621

Cut off rate is 10%. Suggest whether the project should be accepted.

(Ans. NPV Rs.2,284)

10. X ltd is considering to make an investment of Rs.2,00,000 in a machine. There are

two machines are available in the market that is Machine A and Machine B. . The

cash inflows of two machines are given below:

Year Machine A (Rs.) Machine B (Rs.)

1 20,000 40,000

2 60,000 80,000

3 80,000 1,00,000

4 1,20,000 60,000

5 80,000 40,000

Assess the investment proposal by NPV method by assuming the company’s desired

rate of return as 10%.

(Ans. NPV Machine A Rs.42,940 and Machine B Rs.26,840)

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PROFITABILITY INDEX METHOD

11. Calculate Net Present Value and Profitability Index of Machine A and B from the

following information:

Particulars Project A Project B

Initial investment 40,000 60,000

Expected life 5 years 5 years

Salvage value 2,000 3,000

Cash inflows: 1st year 10,000 40,000

2nd year 20,000 20,000

3rd year 20,000 10,000

4th year 5,000 6,000

5th year 5,000 4,000

The management has determined 10% as the desired rate of return for the proposed

investment project.

(Ans. NPV Project A Rs.8,392 and Project B Rs.8,835)

(Ans. PI Project A 1.21 and Project B 1.15)

NET TERMINAL VALUE METHOD

12. Calculate Net Present Value under Net Terminal Value method for Project A from

the following information:

Particulars Project A

Initial investment 20,000

Expected life 4 years

Cash inflows Rs10,000 PA for 4 years

Cost of Capital 12%

Expected Interest rate at which cash inflows will be reinvested

End of the year Percentage

1 7%

2 7%

3 9%

4 9%

(Ans. NPV Project A Rs.28,366)

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13. Calculate Net Present Value under Net Terminal Value method for Project A from

the following information:

Particulars Project A

Initial investment 40,000

Expected life 4 years

Cash inflows Rs20,000 PA for 4 years

Cost of Capital 10%

Expected Interest rate at which cash inflows will be reinvested

End of the year Percentage

1 6%

2 6%

3 8%

4 8%

INTERNAL RATE OF RETURN METHOD

14. The company is planning to invest Rs.60,000 in a project. Life of the project is 4

years. Estimated Net annual cash inflows are:

Year Amount (Rs.)

1 15,000

2 20,000

3 30,000

4 20,000

Calculate IRR.

(Ans. IRR 14.5%)

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15. Mr. A is considering investing 250,000 in a business. The cost of capital for the

investment is 13%. Following cash flows are expected from the investment:

Year Cash Inflows

1 50,000

2 100,000

3 200,000

Calculate the IRR for the proposed investment and interpret your answer.

Ans IRR = 15.5%.

1

SCHOOL OF MANAGEMENT STUDIES

UNIT – III -FINANCIAL MANAGEMENT– SBAA1307

2

3. FINANCING DECISION - CAPITAL STRUCTURE

3.1 LEVERAGE

In general, leverage means to use something that you already have in order to achieve

something new or better. In financial terms leverage means influence of one financial

variable over the other financial variable. James Horne has defined leverage as "the

employment of funds which the firm has to pay a fixed cost or fixed return". If a firm is not

required to pay fixed cost or fixed return there will be no leverage. The use of various

financial instruments or borrowed capital, to increase the potential return of an investment is

known as leverage.

• Leverage refers to the use of debt (borrowed funds) to amplify returns from an

investment or project.

• Leverage is an investment strategy of using borrowed money specifically, the use of

various financial instruments or borrowed capital to increase the potential return of an

investment.

• Leverage is the use of debt (borrowed capital) in order to undertake investment or

project. The result is to multiply the potential returns from a project.

• At the same time, leverage will also multiply the potential downside risk in case the

investment does not get adequate returns.

• The company has to pay fixed cost (interest) which could still decline the company’s

profit. In other words increasing leverage increases the size of the return and increases

the risk

3.1.1 TYPES OF LEVERAGE

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Operating Leverage:

Operating leverage arises from the existence of fixed operating expenses. So the degree of

operating leverage depends upon the amount of fixed costs. If fixed costs are high even a

small decline in sales can lead to a large decline in operating income. Operating leverage may

be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes

in Sales on its EBIT. Operating leverage is related with Investment activities. Operating

leverage can be determined by means of cost volume analysis.

Significance of Operating Leverage:

1. It measures the sensitivity of EBIT to change in sales.

2. It is a measure of business risk.

3. It helps in studying the cost, volume and profit relationship.

Formula:

Operating leverage = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐸𝐵𝐼𝑇

Operating leverage also be defined as % of change in profits resulting from % change in

sales.

Degree of Operating leverage = % of change in EBIT

% of change in sales

When Fixed and variable cost could not apportioned .The above formula could be used . This

is a more practical formula

Financial Leverage:

Financial leverage refers to the use of funds obtained by fixed cost or fixed return securities

(preference and debentures) in the hope of increasing the return to equity shareholders. It may

be defined as % return on equity to the percentage on capitalization. Financial leverage may

be defined as the firm’s ability to use fixed financial costs to magnify the effects of changes

in EBIT on its EPS.

Significance of Financial Leverage:

1. It measures the sensitivity of EPS to change in EBIT.

2. It is a measure of financial risk.

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3. It helps in studying the relationship between operating profit and earnings per share of

the firm.

Formula:

1. If Preference Share dividend does not exist:

Financial Leverage = 𝐸𝐵𝐼𝑇

𝐸𝐵𝑇

2. If Preference Share dividend exists:

Financial Leverage = 𝐸𝐵𝐼𝑇(1−𝑇)

EBIT−I (l−Tax) − Dp

Financial leverage also can be defined as % of change in EPS resulting from % change in

EBIT.

Degree of Financial leverage = % 𝐨𝐟 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒

% 𝐨𝐟 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓

Trading on Equity

Trading on Equity is a financial process that involves taking more debt to boost the

return of the shareholders. Trading on Equity occurs when a company takes new debt, in the

form of bonds, preferred stock, or loans etc. The company uses those funds to acquire assets

to generate a return greater than the interest cost of new debt. Trading on equity is also

known as financial leverage is considered successful if the company generates a profit and a

higher return on investment for the shareholders.

Benefits of Financial Leverage

The financial leverage has various advantages to the company, management, investors and

financial companies. The following are some such benefits:

Economies of Scale: The financial leverage helps the organizations to expand its

production unit and manufacture goods on a large scale, reducing the fixed cost

drastically.

Improves Credit Rating: If the company take debts and can pay off these debts on

time by generating a good profit from the funds availed, it secures a high credit rating

and considered reliable by the lenders.

Favourable Cash Flow Position: This additional capital provides an opportunity to

increase the earning power of the company and hence to improve the cash flow

position of the company.

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Increases Shareholders’ Profitability: As the company expands its business through

financial leverage, the scope for profitability also increases.

Tax Relaxation: When the debts and liabilities burden the company, the government

allows tax exemptions and benefits to it.

Expansion of Business Ventures: The need for financial leverage arises when the

company plans for growth and development, which is a positive step.

Limitations of Financial Leverage

There are certain drawbacks of the financial leverage which are mainly related to borrowings

through debts. These are as follows:

High Risk: There is always a risk of loss or failure in generating the expected returns

along with the burden of paying interest on debts.

Adverse Results: The outcome of such borrowings may be harmful at times if the

business plan goes wrong.

Restrictions from Financial Institutions: The lending financial institution usually

restricts and controls the business operations to some extent.

High Rate of Interest: The interest rates on the borrowed sum is generally high, which

creates a burden on the company.

Benefits Limited to Stable Companies: The financial leverage is a suitable option for

only those companies which are stable and possess a sound financial position.

May Lead to Bankruptcy: In case of unexpected loss or poor returns and huge debts

or liabilities, the company may face the situation of bankruptcy.

A company must be careful while analyzing its financial leverage position because high

leverage means high debts. Also, giving ownership may prove to be hazardous for the

organization and even result in huge loss and business failure.

Composite Leverage/ Combined Leverage:

Combined leverage thus expresses the relationship between revenue on account Of sales and

the taxable income. It helps in finding out the resulting percentage change in taxable income

on account of percentage change in sales.

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Formula:

Composite leverage = Operating leverage * Financial leverage (or) 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐸𝐵𝑇

(or) Combined Leverage = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

EBIT−I (l−Tax) − Dp

(or) Combined Leverage = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛(1−𝑇)

𝐸𝐵𝐼𝑇(1−𝑇)𝐷𝑝

(or) Degree of Combined Leverage = % of change in EPS

% of change in sales

Significance of Combined Leverage:

1. It measures the sensitivity of EPS to change in sales.

2. It is a measure of both business and financial risk.

3. It helps in studying the relationship between EPS and Sales of the firm.

Favourable and Unfavourable Leverage:

When Sales minus (-) Variable Cost exceeds Contribution (or) EBIT exceeds Fixed cost

bearing funds requirement, it is referred as Favorable leverage, When they do not, it is

referred as Unfavorable leverage.

3.1.2 BUSINESS RISK AND FINANCIAL RISK

Operating or Business Risk:

Risk that a business will not be able to cover its operating costs.

Operating risk is the risk associated with the operation of the firm. It refers to the chance a

business's cash flows are not enough to cover its operating expenses like cost of goods sold,

rent and wages. Operating cost is composed of fixed costs and variable costs. Existence of

excessive fixed cost is disadvantageous to the firm. If the total revenue of a firm having a

high fixed cost declines for any reason, the operating profit will reduce proportionately more.

Operating leverage refers to the percentage of fixed costs that a company has. If a business

firm has more fixed costs as compared to variable costs, then the firm is said to have high

operating leverage. Incurrence of fixed operating costs in the firm’s income stream increases

the business risk or operating risk. If a firm has high operating leverage, a small change in

sales volume results in a large change in returns.

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Financial Risk:

Risk that business will not be able to cover its financial costs/financial obligations.Financial

risk is the risk associated with financing decisions of the firm i.e. how a company finances its

operations. The presence of debt in the capital structure creates fixed payments in the form of

interest, which is a compulsory payment to be made whether the firm makes a profit or not. It

increases the variability of the returns to the shareholders

When debt is used by the firm, the rate of return on equity increases because debt capital is

generally cheaper. Therefore use of the debt capital has a magnifying effect on the earnings

of the equity shareholders but it also adds financial risk. The variability in earnings of the

equity shareholders due to presence of debt in the capital structure of a company is referred to

as financial risk. The higher the amount of leverage a company has, the higher the financial

risk which exists to stockholders of the company.

3.1.3 EBIT EPS ANALYSIS

EBIT (earnings before interest and taxes) is a company's net income before income tax

expense and interest expenses are deducted.

EPS – Earnings per share is calculated by dividing earnings available to equity share holders

with number of equity shares.

EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels

of EBIT or under alternative financial plans. It examines the effect of financial leverage on

the behavior of EPS under different financing alternatives and with varying levels of EBIT.

EBIT-EPS analysis is used for making the choice of the combination and of the various

sources. It helps select the alternative that yields the highest EPS.

A scientific basis for comparison among various financial plans and shows ways to maximize

EPS. A tool of financial planning that evaluates various alternatives of financing a project

under varying levels of EBIT and suggests the best alternative having highest EPS and

determines the most profitable level of EBIT’.

A firm has various options regarding the combinations of various sources to finance its

investment activities. The firms may opt to be an

i) all-equity firm (and having no borrowed funds) or

ii) equity-preference firm (having no borrowed funds) or

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iii) any of the numerous possibility of combinations of equity, preference shares and

borrowed funds.

Given a level of EBIT, a particular combination of different sources of finance will result

in a particular EPS and therefore, for different financing patterns, there would be different

levels of EPS.

Statement Showing EPS

Particulars

Sales (SPU*No of Units)

Less Variables Costs (VC per unit * no of units)

Contribution

Less – Fixed Costs

Earnings Before Interest and Tax (EBIT)

Less Interest(I)

Earnings Before Tax (EBT)

Less Tax

Earnings after Tax (EAT)

Less Preference Dividend (Dp)

Earnings Available to Equity Share Holders(EATES)

No of Shares

Earnings per Share (EPS)= EATES/No of Shares

Illustration

Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per annum on an investment

Rs.5,00,000, is considering the finalization of the capital structure or the financial plan. The

company has access to raise funds of varying amounts by issuing equity share capital, 12%

preference share and 10% debenture or any combination thereof. Suppose, it analyzes the

following four options to raise the required funds of Rs.5,00,000.

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1. By issuing equity share capital at par.

2. 50% funds by equity share capital and 50% funds by preference shares.

3. 5% funds by equity share capital, 25% by preference shares and 25% by issue of 10%

debentures.

4. 25% funds by equity share capital, 25% as preference share and 50% by the issue of 10%